Wednesday, January 27, 2016

Housing Part 109 - Asset Classes and Yields

Part of the background of my housing project is the importance of real long term interest rates in home valuations. There is some academic literature on this. But, I think in broader discussions of the topic, the effect of interest rates on home prices is assumed to work through mortgage affordability. This is problematic because mortgage rates are nominal rates. Nominal rates are a combination of real rates and an inflation premium. A decline in either might increase home prices, but they operate in different ways. Falling real rates increase the intrinsic value of the home. The effect is such that falling real rates should not, necessarily reduce the affordability of the mortgage. In fact, considering the long life of a home, if home values are fully exposed to interest rate levels the way other securities are, a falling real interest rate might lead to higher mortgage payments, even after factoring in the lower rate.

A falling inflation premium can increase demand by making mortgages more affordable, in nominal terms. When I first started thinking about the housing bubble, this was my assumption. I thought about it through a finance framework, that the obstacle to nominal financing meant homeowners had earned "alpha" in previous times when interest rates had been high. Since both real rates and the inflation premium were low in the 2000s, I thought that what had happened was that more open access to homeownership had reduced "alpha", and that higher prices weren't so much a sign of excess, but a reduction in the benefits that used to accrue to those with access to credit.

Ironically, that is the story today, in 2016. A lack of broad access to mortgage credit means that homeowners are earning significant "alpha" today. But, since first looking at the issue, I have changed my mind. The housing boom wasn't so much the result of more access to credit as it was the combination of access to credit and a lack of access to building. In many valuable areas, homes can't be built, but for those who want to buy them, credit is available. The difference between 2005 and 1995 wasn't so much the access to credit as it was the lack of access to building.

From BEA table 7.12, with home values from Federal Reserves'
Financial Accounts of US (implied by Consumption of Capital before 1950)

Here is a graph of implied returns to owner-occupied homes since 1929. HUD programs had brought home ownership up to the current range by the mid 1960s. Before that, households tended to rent, and owners tended to have very low leverage. Keep in mind that from the Great Depression until at least the mid-1950s, interest rates on treasuries were very low. So, we can see the high returns to homeowners before the Great Depression, but 3% real returns in the 30s and 40s also represent a high relative return.

But, this excess return appears to have been mostly bid away by the mid 1960s by access to ownership that was facilitated by government programs. This graph shows net total returns to homeownership (green line) and the net returns after nominal interest expense (blue line). We can see that once debt financing became widespread, real total net returns remained in the 2.5% to 4% range that long term bonds generally yielded during that time.

One difficulty is that we don't have market rates for real yields on treasuries before the late 1990s. So, especially during the volatile period of the 1970s and 1980s, it is difficult to confirm these trends. But, in the late 50s, early 60s, and 90s, when inflation expectations were calm enough to roughly estimate real rates, real long term rates and implied housing yields appear to have all ranged in the 3.5% to 4% range. So, alpha from homeownership seems to have been capable of being low for some time.

Here is a chart of mortgage affordability, over time, for Houston (an Open Access city) and San Francisco (a Closed Access city). There were already some supply constraints in the San Francisco metro area (MSA) by the late 1970s, and we can see that here. This graph concurs with these intuitions about home values.

First, we can see in the difference between San Francisco and Houston that the effect of Closed Access policies is a stronger force regarding affordability than the effect of either real or nominal interest rates or than credit access, since local policies are the only factor that differs between cities. Second, looking at affordability in the early 1980s, when inflation premiums were very high, we can see that the obstacle of nominal mortgage affordability did not lead so much to lower home prices as it did to higher mortgage payments. If the demand-side effects of nominal mortgage rates were strong, we would see somewhat stable mortgage affordability levels. The decline in mortgage rates from 1982 to 1995 was generally a decline in the inflation premium. (In fact, real rates probably rose during that period.) And, mortgage payments fell roughly in proportion to interest rates. The demand constraint of high nominal payments appears to have had little effect on home prices.

On the other hand, between 1995 and 2005, real interest rates fell by close to 2% while the inflation premium remained fairly stable, or declined slightly. In Houston, this had little effect on mortgage affordability. From 1979 to 1995, falling inflation brought down mortgage payments with little effect on home prices. From 1995 to 2005, falling real rates pushed up home prices with little effect on mortgage payments.

In San Francisco, the operable effect on mortgage affordability during the 1995-2005 period was sharply rising rents. From 1979 to 1995, mortgage affordability followed roughly the same pattern as it followed in Houston, because the primary cause of the decline was the same in both cities - falling inflation premiums on mortgage payments. But, from 1995 to 2005, there was a divergence. The cause of the rising mortgage payments in San Francisco was a local phenomenon, coming from rising rents.

I think it is interesting to compare the 2000s to the late 1970s. In the 2000s, home prices were rising by close to 10% per year, sometimes more. As households kept taking on larger mortgages, observers complained that those gains were unsustainable, and that those households were overspending for their homes based on unrealistic expectations. But, how is this any different than what happened in the 1970s? Home prices were going up just as strongly then. And, homeowners were taking on mortgage payments that were a large portion of their incomes in order to fund them. So, what was the difference between these two periods?

The difference is that the price increases of the 1970s were part of the broader monetary inflation we had at the time. In that period, mortgage rates were high because inflation was imbedded in the interest rate. Since mortgages can be pre-paid, the mortgage terms also had an imbedded hedge against falling inflation.

But in the 2000s, the price increases came from localized supply constraints, and broader monetary inflation was low. So, in the 2000s, the inflation that affected the housing market was not embedded in the mortgage inflation rate, it was embedded in the price of the house. This difference meant that there was not a natural hedge embedded in the mortgage terms that could ratchet down the cost of the mortgage when home rents stopped climbing.

Of course, as I have pointed out, the local constraints that drive up rents are still operable, and the collapse in home prices was something we engineered at the macro level. After 2007, real interest rates collapsed along with home prices and mortgage affordability, which, when we carefully assess the factors involved in home affordability, we can see is the sign of a significant disequilibrium.

But, thinking about the difference between the 2000s and the 1970s, how should we have expected housing markets to behave? Should they have ignored the persistent rent inflation in the high cost cities? That's the thing about markets. They don't ignore things. And, the policies behind those rising rents are much more entrenched and persistent than the inflationary policies of the 1970s. Homebuyers in coastal California and urban New England in the 2000s were at least as justified when they took on those mortgages as the homebuyers in the 1970s were.

The macro-instability inherent in the housing market of the 2000s was fully a product of the local policies that constrained supply. The instability wasn't caused by the homebuyers that were bidding up prices to reflect those constraints. It wasn't, at its base, caused by the banks that were funding those purchases. It was caused by decades of errant policy development in city halls and regional development committees.

Now, it is true that we can curtail lending enough to counter that instability. That is what we are doing now. Creating stability through credit contraction means falling home prices and rising rents. It means the most financially secure 1/3 or 1/2 of households that are able to secure credit or buy with cash earn excess returns on their imputed rent - the rent they avoid by owning. And landlords can earn excess returns through higher rents from tenants who are locked out of homeownership. And, in the way that we have imposed those credit constraints, that applies in Houston as well as San Francisco. That is why (looking back at the first graph) even though homeowners are as leveraged now as they were in the 1990s, they are now earning returns, after interest expenses, as high as homeowners in the 1950s did with much lower leverage.

On the topic of real interest rates, it occurred to me that one proxy for real interest rates is the Equity Risk Premium (ERP). ERP is a measure of the difference between risk free rates and expected returns on equities, and it is a real (as in, without inflation) measure. This is an estimate, not a market price, but it is a measure for returns to another real asset - corporate equities. Since total real expected returns to equities appear to be fairly stable over time, ERP tends to be an inverse measure of real risk free interest rates.

So, I have graphed here, the implied return on housing (orange), the recent market rates on 30 year real bonds (maroon), 20 year nominal treasury rates minus inflation for the years where inflation expectations should have been somewhat close to actual inflation (purple), and the inverted ERP (green). The 20 year rate measure here probably adds more heat than light. The real rate in the late 1960s was probably slightly higher than the rate estimated by the 20 year rate here. But, sometime during the 1970s, real long term rates probably were as low as the inverted ERP implies.

And, the inverted ERP does seem to be a good proxy for real long term interest rates, as they might apply to housing - until the disequilibrium that began after 2007.

The very high ERP and very low 20 year treasury yield (minus inflation) in the 1970's suggest that home yields should have been lower (home prices should have been higher). This is counter evidence to my speculation above that the high inflation wasn't a drag on home prices at the time. Equities were fetching mysteriously high premiums at the time, which could partly be explained by the tax effects of high inflation. Homeowners would be immune from the tax effects on imputed rent, and some of the tax effects on capital gains, so some of the separation of yields in the 1970s could be from those factors. But, maybe the effect of high mortgage payments on demand did keep home prices down and yields up, relative to other assets, during that period.

6 comments:

Side note: In writing, some employ a "nut graf." That is a paragraph high in copy that sums the story up, including any conclusions.

In academia, the conclusion is often left to the end.

I think journalists are right on this score, and tell you up front what they are going to tell you.

Simple is better in every case.

Sad to say, no matter how effective Kevin Erdmann becomes, I think homeowners are NIMBYists, and so are many other property owners. What retailer wants more retail space zoned nearby? Legal push-cart vending?

I guess there is hope the Fed will recognize the reality on the ground, regarding housing.

Thanks for the input, Ben. Much of the time, I research an idea as I write it. The original nugget of an idea for this post was the graph at the end, and the other ideas that ended up giving this post its narrative ummph were sort of afterthoughts that came as I was writing it. Something like that is usually what happens, and I have purposefully been posting ideas as they spill out, sort of as a record of my thinking process and because I don't want to spend a lot of time editing.

I think I can tell you that I do have support now for this to take the form of a book, which is very exciting. It's a bit strange, because the contents of the book have, more or less, been published on this blog in a sort of Picasso form, and now I have to turn it from cubism to realism.

Regarding academic writing, in the sciences at least, one briefly summarizes one's conclusions in the last paragraph of the introduction; I know the social sciences are different, but scientists don't like surprises, so the conclusion is stated in the introduction part of the paper (Though this may in part be because many scientists frankly hate reading and want to do as little of it as possible; they often say one should be able to understand a scientific paper just from looking at the figures). Not sure what's the norm in economics.